The eurozone self-rescue plan announced last night has three main elements:

750bn euros in a fiscal support program, with 1/3 coming from the IMF (although this was apparently news to the IMF).

The European Central Bank promises to buy bonds in dysfunctional markets.

Swap lines with the Federal Reserve, to provide dollars

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The underlying problem in the euro zone is that Portugal, Ireland, Italy, Greece, and Spain are locked into a currency which means they are uncompetitive in trade terms while they are also running large budget deficits. To get out of this they need large wage and price cuts to restore competitiveness, and they need to make fiscal cuts to get budget balances back at sustainable levels.

Markets decided these adjustments were going to be difficult, so spreads on those countries’ debts widened (i.e., interest rates relative to German government bonds). As the rates go up, this causes local asset prices to fall, concerns over bank balance sheets increase, etc. This combination was causing an incipient run on banks. Any country with its own currency could reasonably devalue in such a situation, but this is not an option within the euro bloc.

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To ultimately get out of this mess, the euro zone needs to grow fast enough to allow nations to grow out of debt. The global backdrop here is very positive in the short term. The jobs numbers in the US last week and strong numbers out of core northern Europe suggest the world can grow. No doubt the ECB and the Fed will use the eurozone scare to justify longer loose policies.

It could be that in two years time Europe’s deficits are much lower, the ECB has hardly bought any bonds, and they have successfully managed a Greek debt restructuring while Spain is out of trouble, and Portugal and Ireland are scraping by in limbo but now isolated problems. With the US likely to still be running near 10% GDP budget deficits – who will seem more risky then? This immediate confidence in the US dollar that has come out of this European crisis could very quickly evaporate.

Alternatively, the underlying fiscal problems in Europe could fester – and the “rules” designed to limit moral hazard may turn out to be a complete paper tiger. In that case, the Europeans again have to make a fateful decision: Do they try to inflate out of the debt burdens of their weakest member countries; or do they instead try to manage selective default, keeping in mind that most Greek debt at that stage will be held by other eurozone governments.